Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Friday, September 14, 2012

More QE? Why Not? What's the Worst That Could Happen?

Well they did it. To no one’s
surprise given the summer’s downward trend in jobs data, the Open Markets
Committee (FOMC) of the Federal Reserve announced additional easing measures,
this time in the form of mortgage backed purchases. A quick refresher: QE1,
initially announced in late 2008, grew to encompass over $1.25 trillion in
mortgage backed securities purchases, mortgage agency debt (Fannie &
Freddie) and a few hundred billion in U.S. Treasuries for good measure. To pay
for it, the Fed cranked up the printing press and grew its balance sheet from
$900 billion to over $2 trillion. On its footsteps in 2010 came QE2, focused on
Treasuries this time, and later Operation Twist, which lengthened the duration
of government debt held. Clearly none of it worked given they are back at it
again. Like a shell-shocked infantryman crawling around the bottom of a
smoke-filled trench searching for anything to stuff in his rifle’s chamber, this
is what they came up with: A promise of open-ended monthly purchases of $40
billion in mortgage securities in addition to reinvesting maturing principal in
similar securities. Operation Twist will be extended and the period for the Fed
Funds rate to be stapled to the floor stretches out through 2015 from mid-2014.
Think about that. Seven years of the overnight lending rate at 0% to 0.25%.
Does this not reek of panic?

Let’s just say….for argument’s
sake….that these measures actually move the dial and prod GDP out of its sub-2%
funk and cause unemployment to dip below 8% (so much for 2008 election
promises). This would redefine a pyrrhic victory as the potential consequences
of such measures are well documented….yet glossed over by the FOMC. The most
immediate (and designed) effect is a rush towards risky assets as investors
know that Ben has their back. During the past few years, Fed purchases have
accounted for between 50% and 70% of new government debt issuance. This crowding out of the market for risk-free
assets has pushed investors further along the risk spectrum. Following in the
paths of QE1 and QE2, softer data over the summer catalyzed markets in
expectation that the Fed would have to take additional measures to spur growth.
Since May the S&P 500 has gained 14%. Copper has risen 15% just since late
summer, and crude is up 25% since July (in part due to rising Middle-East
tensions). Emerging markets…the poster child of risky assets….have gained 10%
as measured by the MSCI EM index. Not quite the 40% rise during QE2, but we’re
not done yet. Conversely the dollar has fallen as it faces additional
debasement with the USD dropping 7.2% against the comatose Euro, hitting $1.30,
and the broader dollar index falling 5.8% since mid-July. Gold, too, has
continued its march upward.

What if the market threw a rally and no one came?

Usually the health of the U.S.
stock market is aligned with that of the country’s population. Not necessarily the
case this time. A characteristic of the post-crisis recovery in share prices is
the absence of market participants. Consistently investors are pulling money
out of domestic equity funds. So when the Fed Chairman speaks of a wealth
effect as citizens giddily open their 401k statements, he skips the fact that
there are fewer investors reaping this paper windfall. And what bounce there is,
is likely offset by the fact that Americans’ largest asset is their home, which
in many cases has taken a 30%-plus haircut over the past half-decade (hence the
MBS focus on QE3…..more on that later). Investors are not stupid and recognize
that the rise in share prices is not being driven by fundamentals but instead
by the Fed’s distorting actions in the markets. The argument of rising share
prices, buttressing corporate coffers and spurring investment, hiring, etc.,
has fallen flat. Without fundamental strength, who in their right mind would
trust these pre-crisis levels? Speaking of fundamentals….and solidifying the
disconnect between Wall Street and Main Street….whatever earnings growth there
has been has not come on the back of rising revenues, but instead by cost
cutting. And in a service economy, that means job-cuts. “Honey, great news. The
401K is up, and I just got laid off.”

The Long Shadow of Short-Sighted Policy

The Fed was correct in its
statement that inflation is within its acceptable range, thus giving it cover
to direct fire at the other half of its duel mandate: the bleak jobs situation.
But Fed action is notoriously lagging (the immediate goosing of financial
markets not withstanding). It will take months to determine whether these new
measure stoke economic growth. It will also take months to see if they have
sown the seeds of incipient inflation, a phenomenan central bankers are
notorious for failing to get in front of. As has been argued in these pages, if
one can count on recent Fed policy for anything, it is for laying the
foundation for price increases. As crude, copper and other industrial inputs
become destinations for yield-seeking investors, the subsequent price gains
will eventually be passed onto consumers. The expansion of the Fed’s balance
sheet only further debases the dollar, making commodities even more expensive
in USD terms. Likewise, imports become pricier as the dollar weakens versus the
currencies of major trading partners. One could argue that a weaker USD will
increase export demand, but that ignores the fundamental reasons why previously
robust exports have tapered off: emerging market growth is slowing and Europe
is still trapped in an endless high-debt, low-growth death spiral.

Housing Appreciation……Since It Worked So Well The First Time

Just as the Fed’s purchase of
Treasuries is meant to push up equity prices and supposedly inspire sufficient
confidence to cause consumers to open their wallets, the focus on MBS is meant
to buttress home prices. By becoming a buyer of MBS, the
Fed hopes to cajole banks to finally deploy their considerable reserves by
originating new mortgages, which can then be passed along to the marginal buyer
(the Fed). In 2011, total MBS new issuance was $1.2 trillion.By purchasing MBS at a monthly clip of $40
billion, the Fed would account for only 39% of new issuance. And this amount is
before the QE3 announcement so any expected bump up in issuance would see the
Fed’s influence on the market diminished.

As with stock market gains being
caused by Fed shenanigans, MBS purchases would create a distortion in the
marketplace and further prevent housing from finding its proper supply/demand
equilibrium. It is a tall task to expect banks to start lending again. Subprime
borrowers are out of the equation, so we can forget about them. Demand for both
commercial and prime residential mortgages has returned. As seen below, banks
have yet to loosen lending standards. As many bad loans have already been
written down, a key reason why banks have yet to lend is fear the property (the
collateral) price will fall, leaving yet another underwater loan. Expecting
prices to rise solely on Fed intrusion into the market is a tough proposition
for a banker to make. Banks getting hammered for robo-signing foreclosures and
other (real and perceived) transgressions at the hands of regulators only
further tamps willingness to lend.

Lastly, what if housing takes
off? Will that really create the job growth, which is supposedly the aim of
these measures? Do home-construction and related services again become drivers
of the economy as they did in the run up to the crisis? As stated here
previously, a robust housing sector should be a consequence of a strong
economy, not a primary source of it. What do artificially supported home
prices do to create high-value, export-oriented manufacturing and
knowledge-based jobs, the kind the U.S. needs to rebalance its economy from an
overdependence on consumption?

Plenty of Blame to Go Around

One is tempted to not blame the Fed
for trying. Chairman Bernanke has reiterated the limitations of monetary
policy and how actions from other government entities would increase the
efficacy of the Fed’s measures. Unfortunately, the administration pulled the
arrow from its fiscal stimulus quiver and shot it straight towards programs
supporting favored constituencies rather than undertaking projects that would
increase national productivity (i.e. shovel-ready infrastructure). Yes the
country was in a crisis, and these good people may have needed the help, but
there was no long-term magnifying effect as promised. Instead, the band-aid
only served to diminish the federal government’s fiscal position. With no
creative ideas from the administration or congress…and with the looming fiscal
cliff…the upside of QE3 is limited and the downside, in the form of inflation
and a debased dollar….may be all we get from it.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.